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Morning Update

Yesterday the VIX continued its march lower, closing in the red along with the S&P 500. It is rare and unusual to see the VIX close down on the day when the market is down, and especially on a Monday. Implied volatility tends to have a slight upward bias on Mondays. This is because the VIX is based on 30 day implied volatility, not 30 trading days. But on Friday market makers know that Saturday and Sunday will have no volatility since the market is not open, and consequently their trading models adjust the VIX slightly downward. On Monday these models need to price VIX based on 30 days again, not the effective 28 days that were used near the close on Friday. Therefore, all other things being equal, the VIX is biased upward on Monday mornings.

Yesterday Pandora saw heavy option trading volume after announcing Dec. 2012 listener metrics. The data came in better than expected with total listener hours up 54% year over year. As a total share of radio listening in Dec. 2012 Pandora accounted for 7.19% versus 4.71% in Dec. 2011, and active listeners increased 41% year over year. The stock finished 0.50% higher on the news despite modest broad market weakness. On top of this, Pandora is now integrated into more than 1,000 products, many of which are being displayed at the Las Vegas at the Consumer Electronics Show right now. This bullish outlook has one option trader positioning himself to take advantage of the potential upside in the stock by selling 7,500 March 8 puts for $0.35.

This trade will profit if Pandora is above 8, 22% lower, at March expiration. If Pandora is below 8 the trader will be “put” to the stock at that price. Therefore by selling this put the trader is saying that they believe the stock is a good buy at that level and want to create yield (17% annualized) while they wait and see if the stock dips to there. The reason premiums are so high in this stock is its volatility. The 30-day historical (realized) volatility in this stock is 77.32%, versus 12.81% for SPY. Currently 30-day implied (expected) volatility in the stock is 60.85%, which means that a 22% moves lower over the next 66 days would be less than a one standard deviation move. Due to the highly volatile nature of this stock selling puts to build a long stock position is definitely the way to go because it helps prevent buying tops and getting whipsawed.

From a technical perspective the $8 level looks like a good point to buy the stock. Pandora has been trading inside of a descending channel since September 2011, which currently puts resistance at 10.75 and support at 6.70. The stock’s all time low is 7.18 and the stock has created some support at 8. By selling the 8 put for $0.35 the effective buy price of the stock becomes 7.65. The stock appears to be poised for a breakout from its descending channel if quarterly earnings are as good as the December data implies. By selling a put instead of buying the stock at the upper end of the channel you can profit from a breakout without adding significant volatility to your portfolio and wait for a great entry into the stock.

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